Harrod-Domar Model

Harrod-Domar Model. The Harrod-Domar model posits that economic growth will increase if the economy raises its rate of savings or lowers its capital-output ratio.

The Harrod-Domar model posits that:

economic growth = s/k

Where s is the savings ratio and k is the capital-output ratio.

Assuming savings equals investment, economic growth will increase if the economy raises its rate of saving. If people save more, banks have more money to lend, firms can borrow more so investment increases. An LDC government could develop its financial and legal institutions so that people trust banks with their money and save more. Alternatively, the government could seek external finance either through foreign loans or aid.

Also, economic growth will increase if the economy lowers its capital-output ratio. If technology improves, the capital-output ratio falls, less capital stock is needed to produce £1 of output so the economy can produce more. The government could decrease the capital-output ratio by giving firms subsidies or tax breaks if they invest in Research and Development (R&D). R&D makes machinery more efficient so capital can produce more output. Alternatively, the government could invest in the infrastructure to make the economy more productive so that capital can produce more output.

Meiji Japan’s investment between 1880-1930 was roughly 12-25% of GDP, economic growth then increased from about 2-3% between 1870-1900 to roughly 6-7% between 1880-1930.

Taiwan’s savings rates were among the highest ever recorded reaching between 30-40% in the 1950s and 1960s. Taiwan’s culture emphasized savings, plus the state kept real interest rates high and tax free. Between 1960-2000, Taiwan’s annual economic growth rate averaged 7%.